I would wager that about the only time most of us take an active interest in the foreign exchange markets is when we're gearing up for a sojourn abroad. Trying to strike the most favourable euro/sterling rate in the weeks leading up to a fortnight away in Mykonos makes sense, so it seems peculiar that many equity investors are either unwittingly exposed to currency risk, or simply choose to ignore it.

To hedge or not to hedge

In fairness, there is no real consensus amongst institutional analysts on this issue, so it's perhaps understandable why retail investors might be reluctant to assess whether their existing portfolios are overly exposed to currency exchange volatility. Indeed, there are some equity-analysts who take the view that currency fluctuations tend to cancel out over time, provided you stay invested long enough. Playing the long game may help to mitigate any exaggerated short-term currency effects, but this strategy ignores the fact that the composition of some investment portfolios renders them far more susceptible to foreign exchange volatility than others. And, above all, it takes no account of long-term currency trends, which can imperceptibly eat away at capital gains. For instance, if you held equity assets in South Africa over the past 10 years ? at least those quoted solely on the Johannesburg Stock Exchange (JSE) - you would have benefitted from a 361 per cent rise in the JSE benchmark over the period. But here's the rub: 10 years ago, one pound sterling would have bought you ZAR 11.6 ? today it would get you ZAR 18.3.

Exposure on two fronts

It's notoriously difficult to accurately predict day-to-day currency movements, particularly as they're not always linked to the relative health of the underlying economy. Instead they're often predicated on unforeseeable factors such as large commodity trades (crude oil brokerage) or manipulation by a central bank. It's an area best left to foreign exchange arbitrage specialists, but that doesn't mean that investors should ignore the issue altogether. Exposure to currency volatility can affect the performance of your portfolio regardless of whether you hold domestic stocks or those traded abroad. Obviously if you have overseas stocks within your portfolio, then you're open to foreign exchange movements both in terms of execution risk and on any income that your investment might generate. In order to buy shares in a foreign stock, your British pounds, shillings and pence are converted to the currency that the security is denominated in (EUR, JPY, US$ etc) and you are essentially left with exposure on two fronts through long positions on both the equity and the foreign currency.

If, say, you had bought shares in Australia's Woodside Petroleum (WPL:AU) at the beginning of last April, the eight per cent capital gain on that investment over the intervening period would be effectively wiped out by a 23 per cent currency exchange movement in favour of sterling over the Australian dollar ? assuming you were to sell the shares now, of course. (A number of our readers have pointed out that broking firms generate fairly hefty arbitrage fees through overseas transactions, so don't count on the full translation effects even if they're in your favour).

If Woodside's dividend was paid in local currency, you would expect that the effective yield would have deteriorated over the period. Conversely, if the Australian dollar had appreciated against sterling, you would be sitting on a capital gain in real terms (subject to execution), and the effective yield on any cash dividends paid would be higher than the quoted rate. However, as a global oil exporter, Woodside actually reports its accounts in US dollars, so the value of any dividends paid to you by Woodside in the form of cash (as opposed to a share-based alternative) would be predicated by the sterling/US dollar exchange rate as at the dividend record date. Alhough we actively encourage investors to consider the potential merits of geographic diversification, there are obviously several issues to take on board, not least of which the fact that dividend income from the bulk of foreign jurisdictions is subject to withholding tax, another potential drag on overall returns for overseas equities ? we covered this in more detail here.

Hedging and financial manipulation

Your investment capital doesn't have to leave these shores in order for you to be exposed to foreign exchange fluctuations. Many UK multinationals employ strategies designed to mitigate any negative foreign exchange movements. This usually involves the use of risk management tools, such as forwards, futures and options. Mining companies, for instance, have traditionally used put options to manage short-term price risk, but this is an increasingly expensive practice. However, there are other companies that simply reject the practice outright. The use of derivatives can be costly, particularly as management will often have to bring in external consultants. After all, it would be wholly unrealistic to expect management from, say, an engineering company to have the requisite financial expertise to set up an effective hedging strategy. Other opponents of the practice assert (with some degree of justification) that currency exposure can seldom be gauged with any degree of precision, or simply that companies cannot actually improve shareholder value through financial manipulation.

Whether or not currency hedging is a legitimate corporate objective is obviously a point of conjecture, but many of our readers will know ? occasionally to their cost ? that negative currency translations can have a deleterious effect on revenues and cash-flows. When you buy into a stock you're allocating capital based on expectations of future earnings and cash flows, so it pays to remember that the impact of currency fluctuations will increase in line with the proportion of earnings that a given company derives from overseas.

Exporters feel the pinch

Certainly, the rise in the value of sterling over the past six months could spell trouble for portfolios that are weighted towards the UK's exporters. At the beginning of this year, Yorkshire-based engineerFenner (FENR), which generates around two-thirds of its sales in US and Australian dollars, said that if its August year-end results had been adjusted for the value of sterling as at 31 December, the group's underlying operating profit would have been reduced by around nine per cent. Similarly, weakness in the South African rand trimmedInvestec 's (INVP) recent half-year operating profits by 2.3 per cent to ?223m. Without rand depreciation, the asset manager estimated that its earnings would have been 13 per cent to the good. As the reporting season unfolds, there will be no shortage of companies bemoaning the impact of negative currency movements, but while some currency risk may be offset by internal controls within large multinational companies, there are some hedging strategies that you could employ if you believe that you are overly exposed.

Currency 'pairs' and exchange-traded funds

As mentioned, instruments such as currency futures and options have long been utilised to mitigate currency risk, but this is probably an unnecessarily complex and costly option for retail investors. You could always utilise 'currency pairs' if you determine that your portfolio of equity investments is highly exposed to the value of a particular currency. Six months ago, if UK shareholders in a US company were worried that their investment was imperilled by a probable fall in the US dollar against sterling, they could have hedged their equity investment by buying sterling and offloading the greenback: GBY/USD (if you buy a currency pair, you buy the base currency and sell the quote currency).

Another related strategy ? at least when sentiment on the global economy turns bullish ? revolves around taking long positions on international currencies that have a strong correlation to global bulk commodities, such as crude oil and iron ore; the Australian dollar and Norwegian krone spring to mind.

An increasingly popular alternative for investors who want to negate exchange rate volatility is the use of exchange-traded funds (ETF). Their growing popularity amongst investors who want to manage currency risk stems from the fact that they're flexible and generally quite liquid. It's certainly the 'no fuss' alternative, with available exposure to a range of international equity markets, but you need to opt for currency hedged funds. Contrary to a common misconception, whenever you buy into a conventional (unhedged) ETF that invests in overseas stocks, you are automatically exposed to the risk of the underlying currency even if the ETF you have purchased is priced in sterling.

Sterling on the rise

Of course, none of this mattered very much following the onset of the global financial crisis. Since then, sterling has generally fared quite poorly against most major currencies. But improved public finances and prospects for growth are now shoring-up the pound, even if the new Governor of the Bank of England seems in two minds over a possible interest rate rise. So with sterling in the ascendant, anyone investing in overseas stocks, particularly as part of an actively traded portfolio, will need to become ever more circumspect. Increased access to derivatives provides options for investors who want to actively manage their currency risk. And there is no shortage of managed funds for overseas markets with in-built hedging mechanisms. However, the underlying point to take on board, particularly as the IC is assessing ever more foreign companies, is the imperative to weigh up currency implications as part of your standard investment criteria.

Abe's odyssey

Japan's embrace of 'Abenomics' provides a clear example of how external (non-market) factors can improve the potential for capital returns, while simultaneously undermining them through currency debasement. In a bid to counter a seemingly chronic deflationary spiral that had taken hold of Japan's economy since the financial meltdown of 1997-98, the newly elected Prime Minister Abe Shinzo ushered in a radical experiment in monetary policy at the end of 2012.

The Bank of Japan switched its policy focus from the overnight call rate to the monetary base of the economy. The Bank subsequently initiated policies designed to double the monetary base at a rate of 13-15 per cent of nominal GDP annually over the first two years. Longer term, there's a more modest goal of 2 per cent 'real' growth rate in the Japanese economy over a 10-year period, which should eventually narrow Japan's sovereign debt to GDP ratio.

The extraordinary fiscal and monetary stimulus under the Shinzo administration certainly had the desired effect on Japan's equity markets. From Abe's ascendancy, the Nikkei 225 peaked at 16,291 points at the end of 2013 ? a rise of 73 per cent. The Nippon benchmark has fallen back by around 10 per cent since the start of this year as Abe has come under criticism for failing to deliver on regulatory reforms linked to Japan's tax regime, its labour market, and a heavily protected agricultural industry. But you would be sitting pretty if you had gone long on the Japanese market at the beginning of last year ? assuming, of course, that you had shorted the yen at the same time. In December 2012, you could have exchanged one pound for 132 yen. A year later, the exchange rate had moved by 30 per cent in sterling's favour, effectively eating into your returns. The opposing movements of Japan's equities and exchange rate were probably predictable, but their exaggerated trajectories less so.

To counter this, investors in individual Japanese stocks could have employed a long-dated GBY/JPY pair, but a more straightforward option exists through hedged ETFs, such as iShares MSCI Japan GBP Hedged(IJPH). On this point it's important to remember that when you're buying into an ETF, you should opt for one that is subject to UK Reporting Status, as any returns under the instrument will not be treated as income for taxation purposes, but rather as Capital Gains.